Gold has enchanted men since time immemorial and the inception of this seduction may be hard to tell, but for sure, the saga continues – from Tolkien’s gold hoarding dragon Smaug to Al Qaeda’s Osama Bin Laden. If you are a netizen, then you would have guessed what I am alluding to. The twitterati has invoked the specter of OBL amidst an ever increasing number of Gold bulls in 2016. And why not? December 31, 2015 had seen Gold trading at $1,060.62/oz and today on 14th April, 2016, as I write, Gold is trading at $1,226.87/oz. Do the math and you will see that it has delivered approximately 16% gain in just 3 months. To many, these are the early signs of a major bull run in Gold. In OBL’s notes recovered during the US Navy SEAL’s compound raid in Abbottabad in 2011, OBL writes in a letter to Atiyah Abd al-Rahman “The overall price trend in gold is upward. Even with a few price drops, I see gold trading over $3000 in the next few years.” OBL was clear. Park Al Qaeda’s proceeds in gold.
Since Uncle Sam’s divorce from the gold standard in 1971, gold has delivered spectacular returns vis-à-vis many other commodities, especially, silver and also the stock market. (Actually, it is contradictory to call gold and silver “commodities” when they are long established “precious metals”).
Let us do the numbers.
Gold vs Stocks
Comparison 1 (1/04/1971 to 14/04/2016)
Dow stood at 830 on April 1, 1971 when the US stopped backing dollars with gold. Value of gold per ounce was $35. Today, Dow is at 17,926 and the value of gold per ounce stands at $1235 (not to mention that it peaked in 2011 breaking $1800 barrier).
Percentage gain in Dow = 2,059%
Percentage gain in Gold = 3,428%
Comparison 2: (14/04/2006 to 14/04/ 2016 – 10 year span)
Percentage gain in Dow: 100%
Percentage gain in Gold: 60%
Clearly, gold is the winner by a substantial margin.
NOTE: A case might be made in favor of stock market considering the fact that stocks do yield dividend (which gold does not) and it has not been factored in while arriving at the conclusion. However, those days are long behind when US was a Goldilocks economy and stocks paid hefty dividends. Even at a highly optimistic average dividend yield of 3.5% over the span, the return would not be enough to outperform the capital gain on gold.)
Gold vs Silver
This makes for a truly interesting comparison and as we shall soon see, the breakout story is hidden right here!
Numbers don’t lie and they are about to tell us a brutally honest account of price discrepancy or price suppression in silver.
Comparison (1971 – 2016)
Percentage gain in Silver: 798%
Percentage gain in Gold: 3,428%
Now, if you feel that such difference in the price gain of silver and gold may be attributed to the supply-demand gap (i.e. demand being less, supply being more), you are surely in for a big surprise.
As it is evidenced in the code of Menes (the founder of Egyptian dynasty – 3100 B.C.), one part of gold was considered equal to two and a half parts of silver as far as 5,000 years back. So, the ratio of price of gold to silver was 2.5: 1. Data shows that this price ratio stands at 15: 1 across the history of mankind. In nature, silver is 17 times as abundant as gold. Therefore, controlling other variables, the gold to silver price ratio should still be 17: 1. Currently, it is 75: 1, indicating that silver is grossly undervalued. Incidentally, demand for silver has been surpassing its supply since past three decades and the demand-supply gap is only going to widen in FY 16-17, exerting tremendous pressure toward an upward shift in prices.
Chinese traders have been using copper as collateral to borrow foreign currencies and invest in high yielding assets. If we were to believe Bloomberg analysts Kenneth Hoffman and Sean Gilmartin, Chinese traders have been hoarding 7 million metric tons of copper or roughly 54% of the annual Chinese demand for copper in 2015. This honeymoon is likely to end as the Chinese authorities start cracking down on these financial arbitrage trades. It is probably simple to guess, then, that the Chinese demand for copper will wane leading to oversupply and a crash in copper prices. The mining activity will cease. It must be noted that silver also happens to be a by-product in copper mining and contributes to roughly 20% of world’s supply of silver. Hence, silver supply will be affected too.
On top of it all, silver has substantially more industrial, commercial and medical applications than gold. In so many of these applications, silver is used in trace amounts and it is not economically feasible to recover such silver especially when it is trading at suppressed prices. Also, the silver mining companies are not faring well, thanks to the ultra-low market prices of silver. Where does all this information lead to? A big gap in supply and demand!
At a time when sovereign bonds are returning negative interest rates, the role of gold and silver as storehouses of value is only going to be more important. Printing more and more money is only going to debase the currency. Silver has been common man’s gold since ages and in times when low fixed deposit rates cannot prevent value erosion against inflation, the common man will look towards silver first and then gold.
In long term, the price of silver has been following the US national debt more closely than most other parameters. As the debt burden increases, so does the silver price. US national debt is at an all-time high at $13 trillion after repetitive stimulus packages. The easy and expected way out of this quagmire would be to make each dollar worth less and hence easy to pay back. This presents a conducive environment for silver to appreciate in price as investors rush towards the exit at once.
Unlike gold, silver prices are not driven solely by investor sentiment. Industrial and medical applications of silver account for roughly 40% of the annual silver consumption. Hence its demand is very “real” and is not subject to big swings in prices very often. On the contrary, since its peak in 2011 (approx. $1850), gold has shown more frequent and more substantial price variations.
What portion of your portfolio should you earmark for precious metals and the mining stocks?
Though not completely analogous, Conn Iggulden captures the essence of people’s (read traders’) behavior very wisely in his book Khan: Empire of Silver:
“If a man has gold, he lives with the terror that someone will take it away from him, so he builds walls around it. Then everyone knows where the gold is, so they come and take it. That’s the way it always goes, brother. Fools and gold, together.”
It was not out of curiosity that the owner of the goose that laid golden eggs slit it; it was greed. Greed that devoured common sense.
History has taught us that the biggest calamities or serendipitous moments arrive when majority of the people have not been expecting them. Markets are in many ways similar to unpredictable natural phenomena. How many times have the Tsunami warnings proven right? How many times have earthquakes struck after forecasts? The sheer unpredictability of markets, whether we like it or not, keeps creating imbalances in prices that allows wealth creation. Time may come when people from taxi drivers to your colleagues and bosses will peddle you free advice on buying gold and gold stocks: after all, most paid advisory services already have. Remember, that is the time when you should get out of the game as the risks are very high. This is a classic recipe for disaster, it is like a haystack with a reckless child sitting next to it fiddling with matchsticks. One reckless move and panic erupts.
Hence, a word of caution: Not only should you choose your basket wisely, but also should be ready to empty it at the right time.
One who is yet to join the buying spree should start with a 20% allocation of his portfolio to precious metals. Let’s say you decided to invest $2 lakh in precious metals.
From my research, this should be the pattern of your investment considering an optimal risk vs reward scenario:
$75,000 in gold
$75,000 in silver
$50,000 in chosen gold and silver mining companies
You can tweak this scenario if you are an investor ready to take on some more risk for extra reward:
$50,000 in gold
$1, 20, 000 in silver
$30,000 in chosen gold and silver mining companies
You may see that major portion of my investment lies in physical gold and silver, not in the mining business and it calls for an explanation.
First of all, it is a fundamental flaw on part of the investors to consider mining, streaming and exploration companies “proxies” for the precious metals themselves.
You might want to consider the possibility that the gold mining company may go bust on account of several reasons including company mismanagement, government instability, change in government policy, geopolitical risks, mining accidents, natural disasters – to name a few. As an investor, I may not feel comfortable knowing the fact that countries like Argentina, Peru, Ghana, Guatemala, Bolivia, Chile, etc. are the top producers. These countries are inherently exposed to a variety of risks that I listed above.
Think over. What if the Mexican miners are not able to sustain profitability in the milieu of unexpected tax increases on mining sector last year? What if an accident similar to the one we witnessed in a mine in British Columbia as a result of tailings dam failure happens? The stock will tumble, or, in some cases the production will go down as well creating a shortage of supply against an insatiable investor hunger for precious metals. This will benefit the actual gold and silver prices. The opposite may not be true, that is, tumbling precious metal prices will never breed an upward trend in mining stocks.
In past 10 years, gold has delivered nearly 100% return, whereas mining stocks have tanked and lost 60% of its value.
But investors can surely benefit from momentum trading for a little while. I sound a word of caution here. The stage is definitely set for a bull run in mining stocks, but may not sustain over a longer period.
And yes, there is more than just a silver lining to the golden thundercloud. Expect silver to rain!
For now, I will leave you all to ruminate and do what your super-investor instinct says!
Dear Tall, Old, Wizened Gandalf the Grey!
As Israelmore Ayivor said: Don’t agree and believe that success comes free… Gold on the floor is a lie! You must dig deep and then you will reap big!
Disclaimer: The author of this blog is not responsible for the outcomes of investment decisions based on the blog content.
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